Darling International, Inc.: Rendering profits

Darling Inc. (DAR), headquartered in Texas, is a leading provider of rendering, cooking oil and bakery waste recycling and recovery solutions to the nation’s food industry. It is the only national publicly traded rendering company and was founded in 1882. Its acquisition of Griffin industries (more on this later) in December 2010 has made the combined company the largest renderer (turning inedible food by-products from meat and poultry processors into proteins, oils, hides and a variety of other value-added finished products), bakery waste and used cooking oil recycler and grease trap service provider in North America.

Darling Inc. operates over 125 facilities located throughout the United States. It has no material foreign operations, but exports a portion of its finished products to customers in Asia, the European Union, Latin America, the Pacific Rim, North Africa, Mexico and South America. Total direct export sales were $ 71.0m, $ 70.8m and $ 132.2m for the years ended January 1, 2011, January 2, 2010 and January 3, 2009, respectively.

Prior to the acquisition, the company’s operations were organized into two segments, Rendering and Restaurant Services (focused on processing used cooking oil into environmentally safe product streams, including fuel and feed ingredients). For FY 2010 74.1% of the company’s revenue of $ 724.9m came from rendering and 24.5% from restaurant services. Though the company’s revenues have fluctuated quite a bit over the last 4 years, varying from a high of $ 807.4m in 2008 to a low of $ 597.8m in 2009, its operating margin as a percent of revenues has held relatively steady at about 13%.

The company’s revenues and cost structure are closely tied to commodity prices. Management believes that the procurement of raw materials rather than the sale of finished products is the most challenging aspect of the business. The company has two primary pricing arrangements for raw materials – a “formula” arrangement where the charge or credit for raw materials is tied to finished product commodity prices. In “non-formula” arrangements suppliers are either paid a fixed price, are not paid, or are charged a collection fee, depending on various economic and competitive factors. Approximately 58% of Darling’s annual volume of raw materials is acquired on a “formula” basis. On the revenue side, substantially all of Darling’s principal finished products compete with commodities such as corn, soybean oil and soybean meal. Diesel fuel and natural gas are significant components of the company’s expenses. However the ability to burn alternative fuels at a majority of its plants helps manage the company’s price exposure to energy markets.

As a result of the acquisition of Griffin, effective January 2, 2011, Darling’s business operations were reorganized into two new segments – Rendering and Bakery Services (collection and processing of bakery waste products into bakery by products). Fat, bone, used cooking oil collection and trap cleaning are included in the Rendering Segment. Darling was primarily a beef renderer, following the acquisition, the company is one of the leading poultry renderers in the United States. All of Griffin’s poultry rendering and bakery feed raw materials are acquired on a “formula” basis and approximately half of Griffin’s finished products compete with commodities

Darling paid $ 872.2m for the Griffin Transaction, comprised of $ 740.5m in cash and $ 130.6m of Darling common stock. As of January 1, 2011, the company had total indebtedness of about $ 710.0m up from about $ 28m as of January 2, 2010, primarily related to the Griffin acquisition. As of Oct.1 2011 the company had pared down the debt to about $ 310m. Revenue for the first nine months of FY 2011, which includes revenue from the Griffin acquisition (~$ 687m), came in at $ 1366.38m. If the increase in sales due to Griffin and increase in finished product prices are backed out, operating income as a percentage of sales for the first nine months of FY 2011 matches that of 2010. Results for the first three quarters of FY2011, indicate that management has done an admirable job of choosing and integrating the acquisition.

If the revenues for the first nine months of FY 2011, less the increase in finished product prices, are projected out the company should be able to generate revenue in the range of $ 1.5b in FY2012. Assuming no synergies from the acquisition, the company should be able to maintain operating margin as a percent of revenues at ~ 13%. Based on the results for the first nine months of FY2011 these assumptions are conservative. If the company manages to grow its net operating profit after taxes at a rate of about 1% from this revenue base, a conservative DCF analysis gives each share a value of around $ 14. The company is currently trading at around $ 13 a share after having recovered from a recent low of slightly above $ 12.

In January 2011 the company entered into a 50%/50% Joint Venture Agreement with Valero Energy (VLO) to design, construct and operate a renewable diesel plant capable of producing approximately 9,300 barrels per day of renewable diesel from recycled animal fats, cooking oils and other feedstock. The company and Valero are committed to contributing approximately $ 93.2m of the estimated aggregate costs of approximately $ 407.7m for the completion of the facility. The ultimate cost of the Joint Venture to the company has not yet been determined. Financing for the project is also reliant on an approximately $ 241m loan guarantee offered by U.S. Department of Energy. The company is also required to pay for 50% of any cost overruns incurred in connection with the construction of the facility. Though the JV has upside potential, it also carries considerable risks for prospective investors.

The company operates in a stable industry. Given the current share price relative to value, it should be a safe buy even in these uncertain times. However volatile macroeconomic conditions may provide those willing to wait with a better entry point.